Meld. St. 2(2009–2010)Melding til Stortinget

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The Management of the

Government Pension Fund in 2013

Published by:

Norwegian Ministry of Finance

Internet address:

www.government.no

Cover illustration: Bjørn Sæthren, 07 Media AS

Printed by:

Government Administration Services 06/2014

Meld. St. 2

(2009–2010) Melding til Stortinget

Forvaltning av Statens pensjonsfond 2013

The Management of the Government Pension Fund in 2013

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The Management of the

Government Pension Fund in 2013

Translation from the Norwegian. For information only.

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1 Introduction ... 7

2 The investment strategy of the Government Pension Fund Global ... 12

2.1 The background to the investment strategy ... 12

2.1.1 Purpose and characteristics ... 12

2.1.2 Main features of the investment strategy ... 13

2.2 Review of Norges Bank’s management ... 14

2.2.1 Introduction ... 14

2.2.2 Background ... 15

2.2.3 The analyses and assessments of Norges Bank ... 17

2.2.4 Report from the expert group ... 21

2.2.5 The Ministry’s assessment ... 23

2.3 Rebalancing of the equity portion 25 2.3.1 Rebalancing of the benchmark index ... 25

2.3.2 Rebalancing of the actual portfolio 25 2.3.3 The Ministry’s assessment ... 26

2.4 Oil and gas equities in the GPFG . 26 2.4.1 Introduction ... 26

2.4.2 The exposure to petroleum price reductions is declining over time . 27 2.4.3 Oil equities and oil price ... 28

2.4.4 The oil price and the financial markets ... 30

2.5 The responsible investment strategy ... 35

2.5.1 Background ... 35

2.5.2 The current framework ... 35

2.5.3 The recommendations of the Strategy Council ... 36

2.5.4 Consultative comments ... 44

2.6 Investments in renewable energy and emerging markets ... 54

2.6.2 External assessments of special responsible investment mandates ... 54

2.6.3 Experience from the Environmental Fund and environment-related investment mandates ... 55

2.6.4 Potential ancillary effects ... 55

2.6.5 Historical return and risk characteristics of investments in developing countries and renewable energy ... 56

2.6.6 Unlisted investments ... 58

2.7 The GPFG and the climate ... 59

2.7.1 Future climate risk initiatives ... 60

2.7.2 Assessment of relevant policy instruments ... 60

3 The investment strategy of the Government Pension Fund Norway ... 62

3.1 Background ... 62

3.2 The investment strategy ... 62

3.3 Rebalancing ... 63

3.3.1 The background to rebalancing .... 63

3.3.2 The Ministry’s assessments ... 64

4 Asset management follow-up ... 65

4.1 Performance of the Government Pension Fund Global ... 65

4.1.1 Market developments in 2013 ... 65

4.1.2 The market value of the Fund ... 65

4.1.3 Return ... 67

4.1.4 Risk and limits ... 73

4.1.5 Costs ... 79

4.1.6 Environment-related mandates ... 80

4.1.7 Operational reference portfolios ... 80

4.1.8 Changes to the benchmark index for government bonds ... 80

4.2 Return measurement in international currency ... 82

4.2.2 Current method for calculating the return on the GPFG ... 82

4.2.3 Choice of currency basket ... 82

4.2.4 Choice of deflator ... 83

4.2.5 The Ministry’s assessments ... 86

4.3 Performance of the Government Pension Fund Norway ... 86

4.3.1 Market developments in 2013 ... 86

4.3.2 The market value of the Fund ... 87

4.3.3 Return ... 87

4.3.4 Risk and limits ... 91

4.3.5 Costs ... 94

4.3.6 The Ministry’s assessment of GPFN performance ... 95

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and compliance framework for

active management ... 95 4.4.2 Independent review of the return

data ... 95 4.4.3 International frameworks ... 96 4.4.4 Folketrygdfondet’s risk

management and compliance framework for the trading

process ... 97 4.5 Responsible investment ... 98 4.5.1 Introduction ... 98 4.5.2 Responsible investment and

active ownership in the GPFG ... 99 4.5.3 Responsible investment and active

ownership in the Government

Pension Fund Norway ... 103 4.5.4 Observation and exclusion of

companies ... 106

Fund ... 109 5.1 Introduction ... 109 5.2 Changes to the mandate for

the GPFG ... 109 Appendix

1 Historical tables ... 110 2 Glossary of terms ... 112 3 Review of Norges Bank’s

management of the Government Pension Fund Global ... 118 4 Framework for the management

of the Government Pension Fund Global ... 121 5 References ... 125

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The Management of the Government Pension Fund in 2013

Meld. St. 19 (2013–2014) Report to the Storting (white paper)

Recommendations of the Ministry of Finance of 4 April 2014, approved by the Council of State on the same day.

(Government Solberg)

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1 Introduction

The Government Pension Fund comprises the Government Pension Fund Global (GPFG) and the Government Pension Fund Norway (GPFN).

The Fund has no governing bodies or employees of its own, and is not a separate legal entity. The GPFG and the GPFN are managed by Norges Bank and Folketrygdfondet, respectively, under mandates set by the Ministry of Finance.

In this report, the Ministry of Finance pres- ents management performance and assessments of the Government Pension Fund for 2013. Fur- ther development of the investment strategy of the Fund is discussed, and an account is given of the management framework follow-up.

The idea of a savings fund

After Norway discovered oil in the North Sea in 1969, it soon became apparent that the values involved might be significant. It was also acknowledged that the revenues from the petroleum activities are not revenues in the ordinary sense, as these are partly offset by the extraction of a non- renewable resource. It was further acknowledged that the revenues would fluctuate significantly with the oil price. It was therefore important, in order to ensure balance in the economy in the short and the long run, to manage the spending of the petroleum revenues of the State. The so-called Tempo Committee (NOU 1983: 27 green paper), chaired by Hermod Skånland, launched the idea of establishing a petroleum fund in 1983. The pro- posal called for the establishment of a fund that could smooth out the spending of petroleum revenues over a limited number of years. However, the Committee had limited confidence in the ability of the State to develop a savings fund – and not only a stability fund. It wrote:

“The political bodies must themselves decide whether such fund accumulation to forestall future revenue reduction is realistic. The Com- mittee chooses, on its part, not to apply such an assumption.”

The idea of a government petroleum fund matured in the 1980s. The Willoch Government advocated the establishment of a fund in the Long- Term Programme published in the spring of 1986, cf. Report No. 39 (1985–86) to the Storting. The Act relating to the Government Petroleum Fund was enacted in 1990 on the basis of a proposition from the Syse Government.

In the beginning, the fund structure was predominantly a bookkeeping exercise. It high- lighted the fact that the petroleum revenues were spent on an ongoing basis: The government petroleum revenues were allocated to the Fund, but the entire amount was returned to the fiscal budget to make up part of the non-oil deficit. In line with the improvements in the Norwegian economy during the 1990s, the first net allocation to the Fund was made in May 1996, cf. figure 1.1.

The Government Pension Fund has over time become an important financing source for government expenditure. In the fiscal budget for 2014, the transfer from the GPFG to cover the non-oil deficit is estimated at NOK 139 billion. This corre- sponds to 10 percent of total expenditure via government budgets. It is estimated that the importance of the Fund as a financing source for government expenditure will increase over the next few years. For 2020, the expected real return on the GPFG is estimated, on an uncertain basis, to correspond to 8¾ percent of Mainland GDP. If expenditure remains at the current level, measured as a proportion of value added in the mainland economy, the Fund may then be financing more than 15 percent of government expenditure.

The said proportion will however decline again in the longer run, since the Fund will not grow in line with the gross domestic product of the mainland economy. The reduction in the financing contribution from the GPFG is concurrent in time with an estimated steep increase in government expenditure, especially on pensions, health and care.

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Good results in 2013

The Government Pension Fund performed well in 2013. The return on the GPFG was 15.9 percent as measured in foreign currency and the return on the GPFN was 15.7 percent as measured in Nor- wegian kroner, before asset management costs.

This is one of the best results over the lifetime of the Fund. Norges Bank’s active deviations from the benchmark index made a positive contribution to the return on the Fund, whilst the management at Folketrygdfondet delivered a negative excess return. At yearend, the overall value of the Gov- ernment Pension Fund was about NOK 5,206 billion, reflecting an increase in value of NOK 1,245 billion over the year.

Last year, the asset management costs of the GPFG and the GPFN accounted for 0.07 percent and 0.09 percent of average fund assets, respectively. The Ministry is committed to cost-effective management of the Government Pension Fund over time. Comparisons with other funds show that the asset management costs of both the GPFG and the GPFN, measured as a portion of assets under management, are low.

The good performance in 2013 reflects the positive developments in global stock markets.

Stock prices appreciated over the year as the result of, inter alia, the US Federal Reserve continuing to provide liquidity to the economy. Devel- oped stock markets experienced a general upturn.

The return on the equity portfolio of the GPFG was 26.3 percent. The high return was fuelled by the developed market investments. The return on the fixed income investments of the Fund was about nil in 2013.

From January 1998 to December 2013, the average annual return was 5.7 percent for the GPFG and 7.1 percent for the GPFN, before asset management costs. Returns have fluctuated significantly over this 15-year period.

The average real return on the GPFG from January 1997 to December 2013 was just below 3.9 percent, net of inflation and asset management costs, compared to just over 3.2 percent measured at yearend 2012. This is slightly below the 4-percent real rate of return expected in the long run.

The return is nonetheless close to long-term expectations, given normal fluctuations in average returns over periods of 15 years.

Figure 1.1 Historical development of the market value of the Government Pension Fund Global.

NOK billion.

Sources: Ministry of Finance and Norges Bank

0 500 1 000 1 500 2 000 2 500 3 000 3 500 4 000 4 500 5 000 5 500

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

1986 The Long-Term

Programme

1990 Government Pension Fund

Act

Mai 1996 First capital

transfer 1998

40 % equities 2001 Fiscal Policy

Guideline

2004 Ethical Guidelines

2007 60 % equities

2008

“All” emerging equity markets 2011 Reduced overweight to European markets.

More emerging markets

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The return on the Fund varies signficantly from year to year, although the recurring income from equities, bonds and real estate in the form of dividends, coupons and rent is more stable. At present, the recurring income of the GPFG amounts to around NOK 130 billion per year, or about 3 percent of the fund capital. The recurring income of the GPFN amounts to just over NOK 6 billion, or about 4 percent of its capital.

Accrued returns account for NOK 1,799 billion of the overall value of NOK 5,038 billion of the GPFG as at yearend 2013. Consequently, more than a third of the value of the Fund is attributable to return on the investments, as measured in international currency. Close to 70 percent of the achieved return is due to return on the equity investments, whilst about 30 percent is generated by the fixed income investments.

The return on the Government Pension Fund has in both 2012 and 2013 been very favourable, relative to the expected rate of return over time.

The Ministry notes that one needs to be prepared for significant fluctuations in the value of the Fund in coming years. Returns have fluctuated considerably over the lifetime of the Fund. Over the period 1998–2013, the annual return on the GPFG has varied between -23 percent and 26 percent.

Corresponding fluctuations would, at current Fund values, represent a decline in the Fund value of about NOK 1,200 billion or an increase in value of NOK 1,300 billion.

Established principles for the management of the Government Pension Fund

The Sundvolden platform states that “the Govern- ment will continue to build on the framework established for the management of the GPFG”.

The overarching objective for the investments is to achieve the maximum possible return, given a moderate level of risk. This enables more wel- fare to be financed over time via the return on the Fund.

Asset management shall be premised on transparency and ethical awareness. A system for responsible investment practices has been established, with companies that violate certain ethical criteria being excluded from the investment universe of the Fund, including serious human rights violations, gross corruption and severe environmental damage. Norges Bank integrates considerations of environmental and social issues in the asset management, and has divested from companies whose business model it has considered to be unsustainable in the long

run. Such divestment takes place within the limit for permitted deviations from the benchmark index. The exercise of ownership rights is based on internationally recognised principles and standards laid down by, inter alia, the UN and the OECD. Responsible investment is discussed in section 4.5.

The investment strategy of the GPFG has been developed gradually over time on the basis of comprehensive professional assessments. Such assessments also underpin the broad support for the strategy of the Fund in the Storting. The long- term investment strategy stipulates a fixed equity portion of 60 percent. The equity portion largely determines the risk level of the Fund. Since the Fund has a good ability to absorb risk, the strategy is not predicated on minimising the volatility of returns. Such a strategy would generate a significantly lower expected return over time. The role of government bonds in the Fund is primarily to reduce the volatility of Fund returns. Their expected return is not high. The equity investments, which give us ownership stakes in companies worldwide, are expected to generate the main contribution to return over time. The investments, in equities, bonds and real estate, provide recurring income in the form of dividends, interest pay- ments and rent.

The investments are diversified across a large number of individual equities and bonds, as well as, more recently, a number of properties.

By diversifying the investments in a portfolio, the overall risk will be lower than the sum of the risk of each individual investment. The Ministry has adopted a benchmark index for the GPFG, which implies that the composition of investments in equities and corporate bonds adheres to the principle of market weights, whilst the composition of investments in government bonds is based on the sizes of countries’ economies, as measured by gross domestic product (GDP weights). The benchmark and the global mandate for real estate investments contribute to investments being diversified across countries and regions.

Over time, most of the risk of the Fund origi- nates from developments in general stock and bond markets, as reflected in the benchmark index. Norges Bank may nonetheless, in its operational asset management implementation, deviate somewhat from the benchmarks, within certain risk limits defined in the mandate from the Minis- try. The contribution to the risk of the Fund from Norges Bank’s deviations from the benchmark index has been moderate over time.

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Section 2.1 of this report outlines the main features of the investment strategy of the GPFG. The investment strategy of the GPFN is discussed in section 3.1. The governance structure of the two parts of the Government Pension Fund is discussed in chapter 5.

Further development of the investment strategy Good long-term management of the Government Pension Fund is premised on widespread support for, and confidence in, the way in which the Fund is managed. The Ministry is therefore committed to assessing, on a regular basis, how the management of the Fund can be developed further. This will be guided by the principle that any changes made to the investment strategy shall be based on comprehensive professional assessments and analyses. Any material changes to the management of the Fund are submitted to the Storting.

This year’s report discusses several themes, including a comprehensive review of Norges Bank’s management of the GPFG, in line with the periodical reviews previously notified to the Stort- ing. The provisions governing the rebalancing of the equity portions of both the GPFG and the GPFN are discussed. Furthermore, there is a discussion about the investments of the GPFG in oil and gas stocks. Previous analyses are updated and expanded in this report. Moreover, the report discusses the advice from the Strategy Council for the Government Pension Fund Global regarding responsible investments. A number of specific measures are also presented in following up on the Sundvolden declaration on investments in emerging markets and poor countries, as well as investments in renewable energy. Finally, there is a discussion on addressing climate issues in the management of the GPFG.

The investment strategy of the Government Pension Fund is premised on the purpose of the Fund, assumptions regarding the functioning of the financial markets, as well as the special characteristics and comparative advantages of the Fund. The investment strategy is characterised by seeking to exploit the long horizon of the Fund and profiting from investments that offer risk premiums over time. Other key elements are broad diversification of the investments, responsible investment practice, cost-effectiveness, moderate limits for deviations from the benchmark index and a clear governance structure.

When the Storting deliberated Report No. 10 (2009–2010) to the Storting – The Management of the Government Pension Fund in 2009, it was pro-

posed that Norges Bank’s management of the GPFG be examined on a regular basis. The background to this is the need for widespread support, also for the operational implementation of the management of the GPFG. The Ministry emphasises that the risk assumed by Norges Bank in its asset management needs to be managed and communicated well.

The Ministry has, in line with this, commissioned a review of the asset management performance of the Bank. The Ministry has also addressed how further delegation of asset management tasks to Norges Bank may improve the ratio between expected return and risk. Both Norges Bank and a group comprising three internationally recognised experts were therefore requested to present such analyses.

Section 2.2 discusses various types of asset management activities that may improve the ratio between return and risk compared to that of the benchmark index established by the Ministry. A limit for deviations from the benchmark index offers scope for improved diversification of the risk in the Fund, and an expected improvement in the ratio between risk and return. However, the contributions will vary over time, and deviations from the benchmark may also deliver negative contributions to the performance of the Fund.

Thus far, the management performance of the Bank has been good. Gross excess return currently stands at about NOK 90 billion on top of the return on the benchmark index. The deviations from the benchmark have over time had a moderate impact on absolute risk. The Ministry does not at present propose any changes to the limit on deviations from the benchmark index, measured by so-called tracking error, but will revert to this issue in the report in the spring of 2015.

Market fluctuations will result in the equity portion of the Fund deviating from the strategic weight of 60 percent. A higher (or lower) equity portion will change the return and risk characteristics of the Fund. Rebalancing is intended to restore the strategic weight, thus ensuring that the risk of the Fund does not over time deviate materially from that implied by the long-term allocation across asset classes adopted for the Fund.

Rebalancing may, at the same time, exhibit certain countercyclical properties, inasmuch as the Fund sells assets that have appreciated in value, in relative terms, and purchases assets that have declined in value. The rebalancing provisions are discussed in section 2.3. It is proposed that tracking error upon rebalancing be excluded from the

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limit for premitted deviations from the benchmark.

Section 2.4 discusses return and risk in oil and gas equities. The main policy measure for reduc- ing the oil and gas price risk of the State is the reallocation of wealth from oil and gas on the con- tinental shelf to financial investments in the GPFG. The Ministry has analysed whether there is reason to expect that the oil price risk can be further reduced by changing the composition of the investments in the GPFG. No changes to the benchmark index are proposed on the basis of these analyses.

The Ministry is committed to that the Govern- ment Pension Fund shall be managed in a responsible manner. Considerable experience has been gained in this area in the last decade, and the responsible investment strategy has been developed over time. The ethical guidelines were intro- duced in 2004. The guidelines were evaluated in 2009. 2010 saw the establishment of a new responsible investment mandate for Norges Bank and new guidelines on the observation and exclusion of companies in which the Fund may invest.

It is the ambition of the Ministry that all aspects of the management of the Government Pension Fund shall be in line with best practice internationally. In January 2013, the Ministry therefore requested the Strategy Council for the GPFG to assess how the collective resources and competencies of the Ministry of Finance, the Council on Ethics and Norges Bank can best be utilised to further strengthen responsible investment in the GPFG.

The report of the Strategy Council was submitted in November 2013 and has been circulated for public consultation. Section 2.5 discusses the recommendations of the Strategy Council, the consultative comments received and the follow-up of the Ministry. In this White Paper the Ministry announces a number of changes that will, in the view of the Ministry, strengthen responsible investment. Among the proposed measures are the integration of all the responsible investment tools in Norges Bank.

Section 2.6 of this report discusses the follow- up of the statements in the Sundvolden platform, in which it is declared that:

“The Government will establish an investment programme within the GPFG, with management requirements of the same scope as for the other investments made under the GPFG, but with the aim of investing in sustainable enter- prises and projects in less affluent countries

and emerging markets. Furthermore, the Gov- ernment will consider drawing up a separate mandate in the field of renewable energy, with management requirements of the same scope as for other investments made by the GPFG. ” In the report, the Ministry proposes, inter alia, that the mandate given to Norges Bank be amended such as to expand the investments in renewable energy.

Previous assessments have concluded that the active ownership and advocacy vis-à-vis coal and petroleum companies will be a more effective strategy for addressing climate issues and effecting changes than to exclude companies from the Fund. The report outlines the follow-up of the request from the Storting for the appointment of an expert group to examine whether these conclu- sions remain viable, as well as shed light on the implications of climate change for the GPFG in general.

Transparent management and a strategy with widespread support

Widespread support for the main principles underpinning the management of the Govern- ment Pension Fund makes an important contribution to enabling us to adhere to the long-term strategy, even during times of market volatility.

Good long-term management is necessary to ensure that the revenues from the petroleum resources will benefit both future and current generations.

The Ministry emphasises that the risk in the management of the Fund must be managed, con- trolled and communicated in a clear and effective manner. Nonetheless, experience shows that it is challenging to uncover all types of risk in advance.

Section 4.4 addresses verifications of return data and independent assessments of frameworks and processes for the management and control of risk.

Transparency is a prerequisite for securing widespread confidence in the management of the Government Pension Fund. The Ministry seeks to facilitate a broad-based debate on important aspects of the investment strategy of the Fund.

Material changes to the strategy are submitted to the Storting. A thorough decision-making process is one of the strengths of the investment strategy.

Alongside the ongoing reporting of Norges Bank and Folketrygdfondet, this report is intended to contribute to transparency and broad- based debate concerning the management of the Fund.

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2 The investment strategy of the Government Pension Fund Global

2.1 The background to the investment strategy

2.1.1 Purpose and characteristics

The Government Pension Fund comprises the Government Pension Fund Global (GPFG) and the Government Pension Fund Norway (GPFN).

Operational management of the two parts of the Government Pension Fund is carried out by Norges Bank and Folketrygdfondet, respectively, and is governed by mandates laid down by the Ministry of Finance. The mandates define the long-term investment strategy of the Fund. This chapter discusses the investment strategy of the GPFG. The investment strategy of the GPFN is discussed in chapter 3.

The purpose of the GPFG is to facilitate government savings to finance pension expenditure under the national insurance scheme and support long-term considerations in the spending of government petroleum revenues. This is stipulated in the the Government Pension Fund Act. Sound long-term management of the Government Pen- sion Fund contributes to ensuring that the petroleum wealth will benefit all generations.

Government revenues from the petroleum activities are transferred to the GPFG. This represents a fairly swift reallocation of wealth. In 2000, the value of expected future revenues from the petroleum sector was close to four times value added in the mainland economy. In 2030, it is expected to be about 50 percent of mainland GDP.

Over the same period, the GPFG is expected to expand from about 30 percent of the mainland economy to about 240 percent.

The objective of the investments in the GPFG is to maximise the international purchasing power of the capital over time, given a moderate level of risk. The mandate of Norges Bank stipulates, inter alia, an upper limit on the Bank’s deviations from the benchmark index defined by the Minis- try. The benchmark index provides a detailed description of how the Fund shall, as a main rule, be invested, down to allocations across individual

companies and bonds. The overall risk in the Fund is predominantly determined by the strategic allocations for equities, bonds and real estate in the benchmark index of the Fund.

The Fund shall, within its role of financial investor, pursue a responsible investment practice that promotes corporate governance and takes environmental and social considerations into account. The Ministry has adopted a set of ethical criteria for the exclusion of companies based on their activities. The criteria are based on a comprehensive review of overlapping consensus in the Norwegian population and recognised international standards.

By diversifying the investments of the Fund across equities, bonds and real estate in a global portfolio, the Fund earns recurring income in the form of dividends from companies, interest pay- ments from bond issuers, as well as rent from properties. By holding a portion of companies worldwide, the Fund can over time reap a return close to the overall return in global capital markets.

The expenses of the Fund are in the form of transfers to the fiscal budget to cover the non-oil budget deficit. The transfers from the Fund are determined by the fiscal policy guideline – which calls for the spending of petroleum revenues over time to correspond to the expected real return on the Fund, estimated at 4 percent.

With a responsible fiscal policy and the inflow of petroleum revenues expected to continue, it is anticipated that the Fund will continue to grow.

The Fund has a very long time horizon. Its special characteristics are of relevance to its investment strategy. Many other funds may risk that return fluctuations result in the owner effecting large withdrawals, but such is unlikely to be the case with the Government Pension Fund. This means that the Fund has a high ability to absorb risk.

The ability to withstand major fluctuations in the value of the Fund in the short and medium run facilitates commitment to an investment strategy that delivers a higher expected return over time.

The management of the petroleum revenues and the GPFG are characterised by a high degree

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of transparency. This is a prerequisite for widespread support for the fund concept and for good long-term management.

It is the ambition of the Government that the Government Pension Fund shall be the best managed fund in the world. Such an ambition implies the identification of best practice internationally in all aspects of the management and the adoption of said practice.

2.1.2 Main features of the investment strategy

The development of the investment strategy of the GPFG is premised on seeking to maximise the international purchasing power of the fund assets, given a moderate level of risk. The strategy is based on assessments of expected return and risk in the long run and is derived from the purpose of the Fund, the special characteristics of the Fund, Box 2.1 Assumptions regarding the functioning of the markets

Well-functioning markets

The investment strategy of the GPFG is based on the premise that the financial markets are largely well-functioning (efficient) in the sense that any new information in the public domain is quickly reflected in financial asset prices.

Risk premiums

The risk associated with developments in the overall stock market is often labelled market risk. Investors who are willing to accept market risk expect to get paid in the form of a higher return than the return on more secure investments. The expected excess return is called the stock market risk premium. The market risk premium is the key risk premium for equities.

A number of equity return patterns have been uncovered over time. Research shows that several properties of equities appear to affect developments in their value over time. It is common to look at properties like value, size, momentum, liquidity and volatility. These prop- erties have turned out to contribute to the expla- nation of historical returns on a broad range of equities and therefore tend to be called systematic risk factors. See the discussion in Report No. 27 (2012–2013) to the Storting – The Man- agement of the Government Pension Fund in 2012.

Economies of scale

The size of the Fund is expected to give rise to economies of scale in asset management. All else being equal, asset management costs measured as a portion of the fund capital will be

lower for a large fund than for a small fund.

Economies of scale also facilitate the development of expertise in all aspects of asset management, which will be of benefit if the investments of the Fund are eventually expanded to include new markets, countries and financial instruments.

Size limitations

A large fund may find it difficult to expand the scale of its positions in small asset classes, as well as certain investment strategies. The impli- cation is that certain strategies are not viable for the Fund. It may also be more challenging for a large fund to change course within a short space of time.

Principal-agent problems

There is not always a complete concurrence of interests between the person for whom an assignment is performed (the principal) and the person who performs such assignment (the agent). In situations characterised by information asymmetries, the agent may make choices that are not necessarily in the interest of the principal. In the capital markets, principal-agent problems may generally arise both between capital owners and asset managers, as well as between asset managers and the managers of the companies in which they invest. Active ownership in accordance with recognised corporate governance principles may serve to reduce principal-agent problems by narrowing the gap between the interests of a company and its owners.

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the strengths of the asset manager, as well as assumptions regarding the functioning of the financial markets. The main features of the investment strategy are discussed below. Some key assumptions regarding the functioning of the markets are discussed in box 2.1.

The long-term investment strategy of the GPFG stipulates a fixed equity portion of 60 percent. The fixed income portion may be no less than 35 percent and the real estate portion no more than 5 percent. This allocation is reflected in the strategic benchmark index of the Fund, which forms part of the management mandate from the Ministry to Norges Bank. The mandate is available on the Ministry website (www.government.no/gpf).

The investment strategy is based on the premise that one needs to assume risk in order to achieve a satisfactory expected return over time.

This expected additional return is called a risk pre- mium. Equities are, for example, more risky than bonds. Investors will expect compensation for this in the form of a higher expected return on equity investments. The magnitude of such expected additional return, or equity premium, is uncertain, and the additional realised return will vary over time.

The choice of equity portion is the one decision with the main impact on the overall risk in the Fund. Other risk premiums are, inter alia, related to the maturity of bonds (term premium) and the risk that the borrower defaults on its obli- gations (credit risk). Operational risk is another type of risk; the risk of loss as the result of inade- quate or deficient internal processes or systems, human error or external events. Operational risk needs to be weighed against investment risk within the relevant limits stipulated in the mandate and by Norges Bank.

When investments are diversified in a portfolio of investments, the overall risk may become lower than the sum of the risk of each individual investment. The investments of the Fund have been diversified across several asset classes over time, and the Fund is currently invested in equities, bonds and real estate. Furthermore, the equity and bond investments of the Fund are diversified across markets in many countries. Moreover, in each market the investments are diversified across a number of individual companies and issuers.

The GPFG holds long-term investments. The equity investments are expected to contribute substantially to the return over time. They do, at the same time, result in increased fluctuations in fund performance. The Fund has a high ability to absorb risk, thus enabling it to adhere to a long-

term strategy despite considerable fluctuations in returns from year to year. Besides, the GPFG is exploiting its long investment horizon by investing in assets that are expected to generate excess return because these may, for short or long periods of time, be less liquid.

The Fund shall pursue a responsible investment practice. It is assumed that sustainable develop- ment in economic, environmental and social terms, as well as well-functioning, legitimate and efficient markets, supports the long-term performance of the Fund. Weight has also been attached to using the available responsible investment tools in a coordinated, predictable and consistent manner. The role of the Fund as a responsible investor is discussed in sections 2.5 and 4.5.

The mandate stipulated for Norges Bank requires the Bank to seek to maximise the return net of costs. This is consistent with the stated aim of exploiting economies of scale in asset management. Comparisons with other large funds show that Norges Bank’s management costs are low.

Over time, management costs as a proportion of the fund capital have declined, cf. the discussion in section 4.1.

The mandate for the GPFG defines an asset management framework in the form of equity and fixed income benchmark indices. The risk in the Fund is principally the result of developments in these benchmark indices over time. Hence, fluctuations in the return on the Fund are predominantly determined by general market developments. At the same time, the mandate of Norges Bank also specifies the scope for moderate deviations from the benchmark indices. See section 2.2 for a review of Norges Bank’s management of the GPFG.

The management of the GPFG is premised on a clear governance structure, in which the Storting, the Ministry of Finance, the Executive Board of Norges Bank, as well as internal and external asset managers all have different roles and responsibili- ties. Duties and authorisations are delegated downwards through the system, whilst reports on results are passed upwards, cf. chapter 5.

2.2 Review of Norges Bank’s management

2.2.1 Introduction

The Ministry announced, in Report No. 10 (2009–

2010) to the Storting – The Management of the Government Pension Fund in 2009, that it intends to assess Norges Bank’s management of the

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GPFG on a regular basis. The report emphasised that the estimated future returns resulting from the Bank’s active deviations from the benchmark index are uncertain. It was noted, moreover, that the limit for deviations from the benchmark index over time needs to be considered on the basis of the performance track record. One prerequisite for continuing to give Norges Bank scope for deviations from the benchmark index is comprehensive assessments of the Bank’s management on a regular basis. It was stated that the resulting con- clusion may be an upwards or downwards adjust- ment to the limits for deviations from the benchmark index. It was emphasised that it was important to examine whether gross excess return con- tinued to be representative of the value added in Norges Bank’s asset management. Another issue mentioned as worthy of attention is whether Norges Bank exploits potential interactions between its active ownership activities and its investment activities.

The Ministry has, in line with this, commissioned a review of the Bank’s management of the GPFG, cf. the discussion in the National Budget for 2014. The purpose is to address how further delegation of asset management duties by way of limits to deviations from the benchmark index adopted by the Ministry of Finance, can be expected to improve the ratio between risk and return. An assessment of the performance achieved over the history of the Fund thus far is an integral part of this.

The Ministry has requested Norges Bank to submit its own analyses and assessments of the implementation of the management of the GPFG, as well as to examine whether the current management framework is appropriately designed and tailored to the asset management strategies in actual use.

Moreover, the Ministry has requested a group comprising three internationally recognised experts (Professor Andrew Ang of Columbia Busi- ness School, Professor Michael Brandt of Fuqua School of Business, Duke University, and David Denison, former President and CEO of the Can- ada Pension Plan Investment Board, CPPIB) to analyse the asset management performance of Norges Bank. The group has also examined how further delegation of management tasks to the Bank can be expected to improve the ratio between risk and return compared to the benchmark index adopted by the Ministry.

Section 4.4 of this report discusses an independent review conducted by the Supervisory Coun- cil of Norges Bank, with the assistance of the

Bank’s auditor, of the risk management and compliance framework for the Bank’s active management.

2.2.2 Background

Experience illustrates that widespread support for the operational implementation of the management of the GPFG is also needed. The Ministry emphasises that the risk assumed by the Bank in its asset management needs to be managed and communicated in a clear and sound manner.

Norges Bank’s management of the GPFG was last examined in 2009. This included analyses and assessments from Professors Andrew Ang, Wil- liam Goetzmann and Stephen Schaefer. The analyses showed that the volatility of returns on the Fund could be almost fully explained by the fluctuations in the return on the benchmark index, although Norges Bank’s management had nonetheless contributed to improving the performance of the Fund. They also showed that a considerable portion of the overall return achieved for the Fund by the Bank could retrospectively be explained by exposure to so-called systematic risk factors. Sys- tematic risk factor is a common term for various return patterns in the equity or fixed income portfolio. One example of such a factor is “value”, which reflects the observation that companies with low valuations have over time delivered higher returns than companies with high valuations.

The Ministry noted, in Report No. 10 (2009–

2010) to the Storting, a number of considerations suggesting that some scope for deviations from the benchmark index is needed, including, inter alia, that Norges Bank should have the freedom to exploit weaknesses in the benchmark index and that the special characteristics of the Fund offer a potential for excess returns over time. These assessments were endorsed by a majority of the members of the Standing Committee on Finance and Economic Affairs, cf. Recommendation No.

373 (2009–2010) to the Storting.

In Report No. 10 (2009–2010) to the Storting, the Ministry decided, at the same time, to change the limit for permitted deviations from the benchmark index; the so-called expected tracking error.

The upper permitted limit of 1.5 percent in the mandate was changed such as to require Norges Bank to organise asset management with a view to keeping the expected tracking error within 1 percent. It was stipulated that the expected tracking error could in extraordinary circumstances exceed the 1-percent limit. The method for calcu-

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lation of tracking error was also changed to make the expected tracking error more responsive to changes in the active positions of the Bank, and less responsive to whether the markets in general are experiencing a period of high or low return volatility. These changes may, generally speaking, reduce the need for keeping well below the upper limit. The report noted that when the upper limit on tracking error was made less absolute, it was also appropriate to reduce the limit on expected tracking error. It was noted, moreover, that the decisive factor in determining the scope for active management is the overall restrictions on the risk in active management. It was therefore an important change that the Ministry required the Execu- tive Board of Norges Bank to stipulate a number of supplementary risk targets in addition to expected tracking error, including limits on over- lap between the actual portfolio of the Fund and the benchmark index, credit risk, liquidity risk, counterparty exposure, leverage, etc. The changes implied, inter alia, that the Bank could not use leveraging to increase the risk of the Fund in the same way as before. These changes to the framework governing the risk of the Fund were based, inter alia, on limits already adopted by the Bank in its internal regulations, cf. Report No. 10 (2009–2010) to the Storting.

Report No. 10 (2009–2010) to the Storting also outlined a number of measures implemented to strengthen control and supervision of the management of the GPFG. The supervision function of the Supervisory Council of Norges Bank was reinforced. New audit arrangements were intro- duced for Norges Bank, and new regulations on risk management and internal control in the Bank were enacted, together with new regulations on annual financial statements, etc. The Ministry also adopted a new Mandate for the Management of the GPFG. A majority of the members of the Standing Committee on Finance and Economic Affairs noted, in connection with the Storting’s deliberation of Report No. 10 (2009–2010) to the Storting, that the amendments made to the mandate of Norges Bank and the measures to strengthen the control and supervision of asset management are targeted measures intended to limit the risk in active management.

In recent years, the Ministry has, against the background of the evaluation in 2009 and the recommendations from, inter alia, Professors Ang, Goetzmann and Schaefer, analysed and examined various aspects of the strategy of the Fund. It has examined, inter alia, whether the Fund can improve the ratio between risk and return by tilt-

ing the composition of the equity portfolio towards systematic risk factors, as well as what decisions should be delegated to the asset manager.

Report No. 17 (2011–2012) to the Storting – The Management of the Government Pension Fund in 2011, discussed the changes to the fixed income benchmark index implemented in 2012.

The Ministry noted that the use of market weights implies that the countries with the largest debts carry the most weight in the benchmark index. It was observed that the size of a country’s economy, measured by its gross domestic product (GDP), provides a better measure of sovereign ability to pay. Hence, the fixed income benchmark index was changed to weigh the government bonds of the various countries on the basis of the GDP of such countries. It was noted, at the same time, that the size of a country’s economy is not a precise measure of the ability or willingness to repay sovereign debt. The Ministry concluded that the mandate of Norges Bank shall require the management of government bonds to take differences in fiscal strength into account. Since fiscal strength cannot be measured precisely, Norges Bank is best placed to make such adjustments.

Moreover, last year’s report discussed an analysis commissioned by the Ministry from the index and analytics provider MSCI. The said analysis examined the effects of tilting the composition of large equity portfolios towards various systematic risk factors like value, size, momentum, liquidity and low volatility by way of simple rule- based strategies, cf. Report No. 27 (2012–2013) to the Storting – The Management of the Govern- ment Pension Fund in 2012. The Ministry concluded that any exploitation of systematic risk factors in asset management should take place within the scope of Norges Bank´s management framework. The Ministry noted that the Bank may design factor strategies based on the characteristics and advantages of the Fund, including the long time horizon and size of the Fund, and that the design of such strategies forms an important part of the management mission of the Bank. In its deliberation of the report, the Standing Com- mittee on Finance and Economic Affairs unani- mously endorsed the delegation of this type of decision to Norges Bank, cf. Recommendation No. 424 (2012–2013) to the Storting:

“The Committee notes the Ministry of Finance’s assessments regarding systematic risk factors in the equity portfolio. The Minis- try concludes that “tilts towards systematic

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risk factors in the equity portfolio [are] best achieved as part of the operational management, rather than through a change in the Fund’s benchmark index”. The Committee agrees with the assessment of the Ministry and notes that Norges Bank has chosen to intro- duce an operational reference portfolio for equities that implies, inter alia, a certain degree of tilt towards the risk factors value and size.”

Besides, the Ministry has noted in previous reports that indices from leading index providers are more tailored to the average investor than to an investor with the special characteristics of the GPFG, such as a long time horizon and a limited liquidity need, cf. box 2.2. As noted by the Minis- try in Report No. 10 (2009–2010) to the Storting, some scope for deviation from the benchmark index adopted by the Ministry of Finance is needed to enable Norges Bank to exploit these weaknesses and ensure cost-effective adaptation to the index. There has been broad political support for these assessments, cf. above.

2.2.3 The analyses and assessments of Norges Bank

Norges Bank has, in a letter of 13 December 2013, forwarded four reports in which the Bank discusses performance and risk in the management of the GPFG, experience from the real estate investments, experience from the environment- related mandates and an evaluation of the strategic plan for the period 2011–2013. Furthermore, Norges Bank has in a letter of 31 January 2014 submitted advice concerning the future management framework for the GPFG. The letters from Norges Bank are enclosed as appendices 3 and 4 to this report. In a letter of 12 March 2014, Norges Bank submitted updated reports based on final results for 2013. The letter and the four reports are published on the Ministry’s website (www.government.no/gpf).

Management performance and risk

The Bank has analysed risk and return over the period from January 1998 to December 2013, with an emphasis on the last five years. The analyses show that the average annual nominal return on the Fund over the said period was 5.70 percent, of which achieved excess return represents 0.31 percentage points. The average nominal return on the Fund over the last five years was 12.04 percent, whilst the achieved excess return was 1.16

percentage points. The figures are not adjusted for asset management costs. The Bank notes that asset management has contributed to an improved ratio between risk and return, relative to the benchmark index. The analyses show that there is some degree of correlation between the achieved excess return and the return on various systematic risk factors, for example volatility and credit. For the entire period as a whole, the systematic factors retrospectively explain 37 percent of the fluctuations in the achieved excess return.

The Bank finds it difficult to draw any clear con- clusions from these analyses because the correlation varies considerably over time.

Norges Bank has also examined whether gross excess return remains a good measure of the results from the Bank’s active deviations from the benchmark index, i.e. whether it adequately expresses the excess return compared to a management scenario in which the index is replicated exactly, net of all costs. Such return difference may be termed net value added. The most common measure is nonetheless the difference between the gross return on the Fund (return before asset management costs) and the return on the benchmark index. This may be termed gross excess return. Whilst gross excess return can be obtained from the annual reports of the Fund, net value added needs to be estimated, since this involves comparing actual returns with theoretical index replication. In order to estimate net value added one would, inter alia, have to take into account the transaction costs incurred in the actual portfolio when phasing in new capital and adapting to changes in the benchmark index, the income earned by the Fund from security lending, as well as the fact that index replication generally involves lower asset management costs. Since estimated index replication income and costs are based on a considerable element of discretionary assessment, the estimated net value added will also be subject to uncertainty. Norges Bank’s cal- culations confirm that gross excess return appears to remain a robust approach to the measurement of value added in asset management.

Experience with the management of the real estate portfolio

The Bank notes that the Ministry decided in 2010 that up to 5 percent of the GPFG shall be invested in real estate. In 2011, the Bank implemented the first unlisted real estate investments, and at yearend 2013 the real estate investments accounted for 1.0 percent of the overall investments of the

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Box 2.2 Index weaknesses The Ministry of Finance has in previous reports

to the Storting explained that indices from leading index providers like FTSE, MSCI, Barclays, etc., generally suffer from a number of weaknesses as a result of the way in which these indices are composed, cf. Report No. 10 (2009–

2010) to the Storting and Report No. 17 (2011–

2012) to the Storting. Indices are designed to meet a number of requirements, including, inter alia, to represent the investment opportunities in a specific market from the perspective of the average or typical investor. This implies that the index needs to be constructed such as to ensure a broad diversification of risk, but also such as to include securities that are liquid, thus making the index investable or replicable. Consequently, the criteria determining what equities or bonds to include in indices are laid down in comprehensive regulations adopted by index providers.

The criteria selected differ somewhat between index providers. This implies, for example, that two equity indices for the same region will not necessarily include the same equities with the same weighting between such equities. There may also be differences in terms of which countries or markets are included in the indices.¹

For an investor with the special characteristics of the GPFG, it may be appropriate to deviate from a strict adherence to the index in order to ensure efficient asset management implementation. Examples of such deviations are:

– Academic studies show that security prices are influenced by large transactions. There is, for example, a tendency for equities adopted for inclusion in an index to increase in price on the day of such inclusion because many large investors are simultaneously acquiring the relevant equities. This indi- cates that there will be costs associated with rigid replication of the benchmark index on the part of the GPFG. Such costs can be avoided by deviating from the index weighting. Moreover, it may be preferable for the Fund to retain credit bonds that are down- graded, rather than to automatically sell bonds when these are removed from the benchmark index. Correspondingly, it may

be appropriate to refrain from buying upgraded securities.

– It is not always possible, or desirable, to hold all securities included in the fixed income benchmark index. The Fund is large and the liquidity of individual securities may vary over time. Norges Bank may therefore opt for putting together a portfolio with approxi- mately the same properties as the benchmark index, instead of acquiring all of the securities included in the index.

– Benchmark index weights do not reflect any other borrowings of a bond issuer. This means that an index weight is not necessarily representative of the overall liabilities of an issuer. A passive asset manager will in principle have to accept the index weights. An asset manager that can deviate from the index may refrain from investing in the bonds of an issuer, or invest less than suggested by its index weight, based on an assessment of the overall liabilities of such an issuer.

– When rebalancing the equity portion it is operationally straightforward to trade entire equity portfolios via so-called programme trades. In the fixed income portfolio, however, one must to a larger extent rely on sell- ing and purchasing individual securities as the result of many fixed income securities being less liquid. Hence, deviations from the fixed income reference portfolio as the result of rebalancing may exceed the deviations from the equity reference portfolio.

– An asset manager conforming strictly to the index will, for example, incur high transaction costs when there are frequent changes to the fixed income index. Moreover, an asset manager that is not permitted to deviate from the index must in principle divest a bond when its term to maturity is less than one year.

1 By way of illustration, Ang, Brandt and Denison have in their report calculated that the difference between a global index from the index providers FTSE and MSCI may represent a tracking error of about 0.5 percentage points, although both indices are aiming to capture developments in global stock markets.

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Fund, with a value of NOK 52 billion. The average annual return achieved since inception of the real estate investments in 2011 until yearend 2013 was 4.6 percent, measured as time-weighted annual rate of return. The report from Norges Bank provides a comprehensive overview of the investments and the Bank’s organisation of these activities, including the governance model and company structures. The Bank notes in the report that investments in unlisted real estate differ significantly from investments in listed equities and bonds. The strategy of the Bank in the introduc- tory phase was to invest in properties in the core markets, first in Europe and thereafter in the US.

The Bank has focused on investing alongside local partners via so-called joint ventures. It is noted that such partners have local market knowledge and that they are currently responsible for the operation of the properties. Internally at Norges Bank, there has been a commitment to making investment decisions within a structure based on the delegation of powers. Moreover, the Bank has focused on establishing an investment organisation for real estate that is similar to how the other parts of asset management are organised, rather than on establishing an organisation that follows up on external management mandates. All the unlisted real estate investments of the Fund have been implemented via subsidiaries of Norges Bank. The Bank has been committed to allowing plenty of time for the phase-in of real estate into the Fund, and believes that the implementation has been characterised by the prudent development of resources, systems and frameworks.

Experience from the environment-related mandates In its letter of 13 December 2013, Norges Bank notes that the Ministry decided to establish a specific programme for environment-related mandates in connection with the evaluation of the ethical guidelines in 2008–2009. Since 2009, the Bank has allocated internal and external management mandates that are specifically focused on environment-related investments. These investments are subject to the same profitability requirements as the other investments of the Fund. The report from Norges Bank notes that the Bank has thus far chosen to concentrate the investments on equities in listed companies. It is noted that the investment universe for this type of mandate is complex, and that environment-related companies can be found in a number of industries, each of which may have very different characteristics. The Bank therefore notes that such investments involve a

number of definition problems. The risk in this part of the market relates, according to Norges Bank, especially to swift technological development, rapid inflow of new market players and unpredictable framework conditions. The period since the establishment of the environment- related mandates has overlapped with a global financial crisis. The Bank notes that the crisis contributed to increased volatility in this part of the market, and had a negative impact on investors’

appetite for risk. Norges Bank notes that this market segment is relatively small, but is of the view that the Bank can handle the current volume of investments in environment-related mandates. It is stated that the overall return on the environment-related mandates of the Fund was 13 percent over the period 2009–2013, whilst general stock market returns, as measured by the equity benchmark index of the Fund, was 54.1 percent over the same period. The Bank is of the view that environment-related investments are well suited for active management, although these have not contributed to the healthy return on the Fund over the period 2009–2013.

Evaluation of the strategic plan for 2011–2013

Norges Bank notes that the strategic plan for the period 2011–2013 was adopted by the Executive Board on 15 December 2010 and forwarded to the Ministry for information, in compliance with the requirements in the mandate. The main objectives for the period were the implementation of an investment strategy premised on the special characteristics of the Fund, simplification of the organ- isational and technological infrastructure and strengthening of the investment culture at the Bank. The Bank’s report shows that the organisation has been changed to focus more on high returns in the long run. Moreover, Norges Bank has simplified the portfolio structure and technological infrastructure, and also reduced the number of external service providers. This has, according to Norges Bank, resulted in lower management costs. The Bank has also strengthened its investment culture through better and more focused investment analysis. Public reporting on the management of the Fund has also been strengthened.

Interaction between active ownership and active management

Norges Bank notes that it is using a number of responsible investment tools. It promotes inter-

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national principles and standards, expresses expectations as owner and exercises ownership rights through voting and engagement with companies. Corporate governance, environmental and social considerations are integrated in the investment process and in risk management. The Bank notes that this may result in portfolio adap- tations, such as decisions to divest, or to refrain from acquiring, certain securities. The Bank believes that there are interactions between the various ownership tools and the investment activities in general.

The active ownership involves the analysis and accumulation of knowledge about matters that may be of relevance to the long-term returns of companies. It is noted that corporate governance, environmental and social considerations can have an impact on investment returns and risks. The Bank is of the view that the anticipated benefits from divestment of companies should be weighed against the interest in being invested in a large number of companies. It is noted that large-scale divestment may impose costs on the Fund in the form of a lower degree of risk diversification.

The Bank also notes that knowledge accumu- lated as a basis for investment decisions may benefit active ownership. Norges Bank meets repre- sentatives of the companies in which the Fund is invested, on a regular basis, through its investment activities. The Bank notes that this forms the basis for a good dialogue on ownership issues.

Moreover, the Bank accumulates, through the investment activities, knowledge about many of the companies in which the Fund is invested.

Such knowledge contributes to ensuring that its active ownership activities are relevant and premised on a comprehensive understanding of individual companies and issues. This may, according to the Bank, improve the scope for positive results from active ownership.

In prioritising its ownership activities, the Bank takes the composition of the Fund into account. The Bank has experienced that it is especially important to consider active ownership and investment decisions in the context of each other in companies where the Fund is a major owner.

The Bank also takes into account whether an issue can be said to be of material importance at the company level, and whether it may have an impact on the valuation of the company. The Bank is of the view that the dialogue with companies becomes more consistent when active ownership is considered in the context of investment decisions.

Advice on the management framework

In a letter of 31 January 2014, Norges Bank has submitted advice relating to the GPFG management framework, including the limit for deviations from the benchmark index adopted by the Minis- try. Norges Bank is proposing a number of adjustments to the mandate for the GPFG, including that the Bank should be given somewhat more freedom of action in its implementation of the management mission by way of the responsibility for laying down detailed provisions being, to a larger extent, delegated to the Bank. The Bank believes, inter alia, that requirements for the assessment of credit risk in the fixed income portfolio and for establishing appropriate limits for this type of risk should be the responsibility of Norges Bank. Moreover, the Bank proposes a number of simplifications and a new structure for the mandate. The Bank notes that the risk management measure expected tracking error suffers a number of weaknesses as a management param- eter for risk taking in the implementation of operational asset management. The Bank believes that one should in the longer run consider whether to instead base the management of the Fund on a measure of absolute risk. If the risk measure for the management of the Fund shall continue to be based on a limit on expected tracking error, the Bank is of the view that such limit should be increased from the current limit of 1 percent to 2 percent.

Norges Bank notes that several provisions in the investment mandate of the Bank have been amended in recent years in a way suggesting that there may be a need for increasing the limit on deviations from the benchmark index. The most important of these are the rule on how to rebal- ance the equity portion, the requirement for taking differences in fiscal strength between countries into account in determining the composition of the government bond investments and the requirement for establishing specific environment-related investment mandates.

The Bank notes, moreover, that it has established, through modification of the operational reference portfolio, a more tailor-made basis for its asset management. The deviations between the operational reference portfolio and the benchmark index adopted by Ministry of Finance draws on the limit for expected tracking error. It is also noted that asset management has in recent years evolved towards harvesting systematic risk premiums through, inter alia, modification of the operational reference portfolio. Norges Bank believes